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April 1, 2000

It's Not What You Earn

Terry Banet at the J.P. Morgan Tax Aware U.S. Equi

It was while working with wealthy individual investors at J.P. Morgan & Company that Terry Banet perfected the tax reduction strategies she uses as portfolio manager of the J.P. Morgan Tax Aware U.S. Equity Fund. Ever sensitive to the tax consequences of her clients' investments, she now runs a fund that takes the bite out of capital gains taxes for the average investor. "We manage a tremendous amount of assets for our private clients using a tax-managed model, which is one reason they hire us," says Banet. "We've applied that approach to the way we manage the fund. It's a long-term strategy."

Since its launch in December 1996, the Morgan Tax Aware U.S. Equity Fund has made no capital gains distributions. That's been a boon to investors, who retained nearly all the fund's earnings. As of January 31, 2000, the fund's three-year annualized total return was 22.9%, with dividends reducing the return by a mere 0.3%, bringing the tax-adjusted return to 22.6%.

Banet's goal is to match or outperform the S&P 500 on a pre-tax basis - which the fund's three-year total return did by 0.02%. In 1997 and 1999, however, the fund trailed the index. "At the end of 1999, we had problems with Tyco, and we didn't own Qualcomm, Yahoo!, and Nortel, which brought us down," explains Banet. "But year-to-date 2000, we're running 480 basis points ahead of the index, which more than makes up for our performance in 1999. I feel pretty comfortable where we are. Some years, stock picking will be better than others."

Tax-efficient funds like Banet's sprang up in 1997, when the capital gains tax rate was lowered to 20% on investments held longer than 18 months. That meant a buy-and-hold strategy could translate to higher returns for investors. How significant is the difference between pre-tax and after-tax returns? According to Morningstar, the average U.S. diversified equity fund delivered a three-year after-tax return that was 2.5% lower than its pre-tax return. In contrast, the average tax-managed fund lost only 0.5% to taxes. "That 2% compounded over 10 years is going to be a big number," says Banet. Critics of tax-sensitive funds call them a marketing gimmick that uses the promise of low taxes to disguise mediocre returns. But that's not the case with this fund. The J.P. Morgan Tax Aware U.S. Equity Fund, classified as large blend, outperformed its category. The average large blend fund had a 12-month return of 11.2% and a three-year annualized return of 19.3%, compared to the Morgan fund's 16% and 22.6%, according to Morningstar. Based on its three-year return, the four-star fund is ranked in the top 20th quintile of large blend funds.

Banet uses a variety of techniques to minimize taxable distributions. Besides holding stocks long term and harvesting losses to offset gains, Banet will also sell the highest-cost shares first to limit profits, and buy back shares after 31 days to avoid the IRS' "wash sale" tax penalty. Liquidating shares also generates capital gains, so Banet discourages selling via a 1% redemption fee within the first year. And shareholders who redeem more than $250,000 in fund shares may receive a redemption in kind - stocks instead of cash. "We did about a dozen of these last year where the investor got a slice of the portfolio, about 20 to 30 stocks," says Banet. "So I didn't have to sell stocks to raise cash to redeem those shares."

During Banet's 15 years with Morgan, she has worked in U.S. and international private banking services and continues to manage assets for private clients. When we caught up with her, Banet was driving from Washington to Baltimore in a downpour to have dinner with a client.

What techniques do you use to reduce your fund's capital gains? First, we make sure we're using good tax-lot accounting. We identify every tax lot, when it was purchased, and its cost. Then we identify the most advantageous use of each tax lot. Next, our staff of 23 analysts does fundamental research on the companies, looking at competitive advantages, the industry dynamics, etc. From this, they build their valuation models to project long-term cash flows and expected returns.

Say I want to buy a new stock because it has a higher expected return than the one I'm holding. But I bought the one I'm holding at lower cost, and it might have an unrealized gain. You have to make sure the expected return on that new stock is high enough to make up for the taxes you have to pay on the one you're selling. Think of it as a break-even analysis. If the trade meets that break-even analysis, we'll do it.

Now, the break-even analysis will be different even though you have two lots of AT&T, both purchased at $40. One might be a long-term holding taxed at a 20% rate, and one might be short-term taxed at 39.6%. Our break-even analysis has all the tax rules built into it. If the trade doesn't cut the mustard on the break-even analysis, then we look for a loss in the portfolio that can offset the gain. That may sound easy, but at the same time we are trying to control risk in the portfolio. How big a bet do we want to take on different stocks or on any sector? We have 500 stocks in the S&P and thousands of tax lots in the portfolio. So we built a computer model to consider these tradeoffs so that our buys and sells make sense on an after-tax basis.

Can you give some examples of those techniques? In the consumer sector, Unilever was at a loss and Clorox had a higher expected return than Unilever. That was an easy swap. A more difficult situation was Best Buy, which had a huge embedded gain. We bought it at about $9 a share. When it was $57, we had a $48 gain taxed at 20%. That meant paying almost $9.60 a share in taxes! We'd have much less to reinvest in the new stock we wanted to buy. So we used some of the losses last year in Service Corp. and some of our bank stocks to offset the Best Buy gain. Because of the market's volatility, we've always had offsetting losses. People ask, "Well, if you're always offsetting gains and losses, how does the fund ever make money?" The answer is, there is still an embedded gain in the portfolio. We have unrealized gains in excess of any unrealized losses.

Can you describe your process for making buy and sell decisions? We use a proprietary valuation model to rank stocks. The model gives us an expected return on each stock, and we rank those from highest to lowest, sector by sector. The top 20% becomes the first quintile and the next 20% the second, and so on through the fifth quintile. We want to buy stocks in the first and second quintiles and sell in the fourth and fifth.

For example, when I bought Level 3 in mid-1999, it was trading at $54 a share and was in our first quintile because it was attractively priced relative to the other stocks in the telecom sector. Today it is $125 a share - up more than 100%. Because it is so expensive and other stocks in the sector, like AT&T and SBC, haven't gone up as much, Level 3 is less attractive because it's already had its growth. Our analysts haven't changed their estimates of the stock, so it's moving down in the rankings. Once it's in the 4th or 5th quintile, it's a candidate for sale.

J.P. Morgan

Tax-Aware U.S. Equity

J.P. Morgan Investment Management, Inc.

522 Fifth Avenue

New York, New York 10036

212-837-2300

Portfolio manager: Terry Banet

Manager's tenure: 3 years

Fund started: December 1996

Minimum initial investment: $2,500

Load (front-end): 0%

12(b)-1 fee: 0%

Net assets: $178.9 million

Dist. yield (trailing 12 months): 0.52%

P/E ratio: 37.1

P/B ratio: 10.1

Median market cap: $98.02 billion

Expense ratio: 0.85%

Turnover: 44%

3-year alpha: 1.35

3-year beta: 0.95

3-year r-squared: 96

3-year standard deviation: 20.22

Returns

1998:

18.31%

1997:

31.18%

1996:

30.32%

1995:

NA

1994:

NA

12-month (annualized):

16.08%

3-year (annualized):

22.57%

5-year (annualized):

NA

Top Five Holdings

Cisco Systems:

4.90%

Sun Microsystems:

4.70%

Microsoft:

4.34%

Exxon Mobil:

4.30%

General Electric:

3.30%

Equity Allocation

As reported in the March issue of Morningstar's Principia Pro.

Annualized returns are through February 29, 2000.

What triggers the sale of a stock you intend to buy back? If a stock is at a loss, we'll contemplate using it to offset a gain. If it's a stock that we truly like and is still high in our rankings, we have two possible approaches. One, we can decide to live without this stock for 30 days and take the risk that the stock will go back up. In that case, we would sell the stock and buy it back 31 days later. The other situation happened with Tyco. At the end of the year, issues about the company's accounting practices surfaced. The stock dropped to about $28 a share, and I had a big loss. However, there wasn't anything broken with the company, and I thought confidence in Tyco might return very quickly. In that case, we weren't comfortable being out of Tyco for the wash-sale period. So we bought more Tyco shares and held them for 30 days, and on the 31st day, we sold off the losing lots. We complied with the wash-sale rules but stayed positioned to recoup the losses. Tyco did rally from $28 to $42.

Do you only buy stocks that pay small or no dividends? No. When we did the initial research on our model of investing, we looked at the effect of tilting away from or not holding dividend-paying stocks. And we weren't pleased with what we had to eliminate. But I would rather have returns from stock appreciation, because if you sell, they're taxed at a capital gains tax rate, which can be 20%. In contrast, dividends can be taxed at the highest marginal tax rate of 39.6%.

How do you factor in opportunity costs? Don't some of these tax-avoidance parameters keep you out of some great stocks? Our break-even analysis considers that factor. If you find a great stock that you think is going to have a superior expected return, then you look for what you can sell to realize that return after tax. If you don't have anything to sell, then you might have to miss out on the one-time runner stock. You may actually do better for your client on an after-tax basis by not buying that one great stock if you have to take a ton of gains to get it.

Some say tax-managed funds are a marketing gimmick since many portfolio managers limit turnover and offset gains with losses. The turnover on the fund two years ago was between 30% and 40% and last year it was 44%. That's low in comparison to your average large-cap fund, but it's quite high in comparison to a fund that advertises low turnover. However, a fund with 10% turnover - all of which are in short-term gains - may not be accomplishing anything. I might make three or four different trades without incurring taxes. I don't think it's a gimmick because we're outperforming the S&P for the last three years and we haven't made any capital-gains distributions. We carry forward losses so we keep dry powder in the keg. We can take gains right now that will not cost us anything in the way of taxes.

But portfolio managers often offset gains with losses. The average mutual fund doesn't do that. It has distributions on an after-tax basis. By our calculations, the average large-cap fund was up 19.37% at the end of 1999. After taxes, the return was only 17%. They lost almost 2.4% of their return because they had very large distributions.

Why would an investor choose a tax managed fund over an index fund? An index fund is reasonably tax efficient, but a tax-managed fund can be more tax efficient, through active management. For example, Deutsche Bank bought Bankers Trust in a cash transaction. The index funds had to take that as a taxable event. For another, there were some stocks last year that didn't do particularly well. Index funds don't have the ability to sell those stocks because they must remain pure to the index and maintain their weighting in those stocks. In contrast, the tax-managed fund can sell those stocks and outperform the index.

Is there a typical investor for your fund? Our investor is someone who cares about taxes. Even if you're not getting the absolute highest pre-tax return, you are getting a good after-tax return. And that is a prudent way of investing because at the end of the day, you're better off. If you are going to take a lot of short-term gains, you need an awfully good return to make up for the fact that you are paying away 40% of those gains in taxes.

A tax-managed fund merely postpones the pain of taxes. When you sell after 20 years, you'll still have to bite the bullet and pay up. Sure, but if they are long-term investors, the tax will be at the long-term gains rate. And deferring taxes over years can make a very big difference in your wealth when you consider compounding. Also, if they hold shares until they die, they may get a step up in basis and never have to pay the capital gains taxes.

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